Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Friday, November 9, 2012

What a Second Obama Administration Means for Investors and the Economy

Had I not run out of room, I would have include the word stakeholders in the title, reflecting
the mission of these pages, which is to demonstrate how market-related data and
economic policy cage-matches ultimately impact us all. Valuations in financial
markets, after all, should reflect broad economic prospects …that is when the
Fed is not making Herculean efforts to contort asset prices. Rather than add to
the pyre of analyses of the recently completed election, we shall instead
divine what lies ahead for financial markets and the broader economy within the
context of subjects with which we have repeatedly inundated our readers, and
for good reason. For these are the issues that the Administration must address
in order to catalyze what even top officials admit has been a disappointingly
slow recovery. Chief among them is a return to a growth rate sufficient to
consistently create jobs, as there is still much ground to make up on that
front. Of the 8.4 million jobs lost since just prior to the official onset of the recession, only a
little more than half have returned.

If this task was not arduous enough, the Administration must address
the January 1stFiscal Cliff,
a growth-sapping combination of tax increases and spending cuts that likely
would hurl the country back into recession. And to make it even more of a
Maalox moment, these near-term steps must be accomplished in a landscape of
consumer (and supposedly government) deleveraging, which robs the economy of
the credit-driven fuel prevalent in previous recoveries. Washington must also
finally pay heed to the reality that the U.S. economy has to rebalance away
from egregious consumption and more towards producing things the rest of the
world cannot wait to get their hands on.

War Criminals, Flesh-Eating
Zombies and Capitalists

Many of these issues would be simpler to solve with a return to
consistent…and ideally above trend, to make up for lost time….growth. A growing
economy would create a larger pool for government revenues, making it easier
for lawmakers to avoid painful decisions on the right mix of austerity measures,
because, as we all know, legislators on both sides do not like making painful
decisions. Unfairly or not, the President’s first-term record….as well as his
William Jennings Bryanesque campaign rhetoric….is often interpreted as being mildly hostile to business. Should the
administration recognize the key role a private sector unencumbered by
excessive regulation plays in driving growth, much of the heavy lifting with
regard to job creation and rising incomes will be done for it. If, instead, the
President confirms that his instincts are to distrust private enterprise,
seeing it as a barely tolerable, but necessary, evil, which exists only to
execute centralized bureaucratic edicts, and it is government that truly is in
the captain’s chair when it comes to guiding the economy, he can look across
the Atlantic for a view of what is in store for an over-regulated country with
a bloated, and often inefficient, public sector.

The Major Hurdles

Europe’s real time self-immolation provides evidence of what occurs to
countries with low growth and high levels of debt. Despite such a grisly
spectacle, Washington continues to punt by ignoring the Bowles-Simpson
Commission’s recommendation, failing to reach a grand bargain in 2011, and most
recently recklessly allowing the country to veer perilously close to the Fiscal
Cliff. The chances of a lame duck congress devising a long-term solution are
nil, so likely there will be a Band-Aid placed upon a massive hemorrhage until
the next congress is in session.

As seen above, the government deficit as a percentage of GDP is
estimated to remain above 4% over the next five years. With interest rates so
low (more on that later) the country can finance this imbalance on the cheap.
Eventually QE will end and rates will normalize. Should the deficit not be
under control by that time, the elevated interest payments will add to an
already unattractive debt load. Unlike Europe, the U.S. has the advantage of being
home to the world’s reserve currency (the one in which all its debts are
denominated) and is the issuer to the putatively safest financial assets on the
planet. These facts have allowed policy makers to repeatedly avoid addressing fiscal
warning signs as they assume the current reality is immutable. For the
short-term, as the Euro burns and China’s growth (and leadership woes) mount,
they are likely correct. In the long-run the assumption becomes much riskier.
Leading economists, such as Ken Rogoff, have studied at which level of debt is
economic growth impacted. The range starts anywhere between 80% and 100% of GDP;
the U.S. is currently north of the latter figure. In the sub-2% growth world in
which we reside, only a dip of only few basis points puts the country
perilously closer to recession.

The key step in avoiding such a scenario is to curtail government
spending…..something in which Washington has a pathetic track record. The chart
below shows that government’s share of GDP is now above 20%, yet this is before
Obama’s eponymous legislative achievement fully kicks in. Should one prescribe
to the notion….which we don’t…..that government activity in the economy has a
magnifier effect, then a 20%-plus slice of GDP would be swell. With that
rationale why not increase it even more to catalyze greater economic growth?
That’s the French model. And as we know, the ossified Gallic economy is nothing
more than another sickly PIIG, with slightly better public relations and tasty
foie gras.

Perhaps the best way to measure the Administration’s efficacy in
tackling these issues as events unfold is to map out potential reactions in
financial markets, which in turn, will impact everything from the rates on our
mortgages, prices at the pump and our 401k statements.

Fixed Income: A Tilted Table

Rather than rehash last week’s posting on how the Fed has distorted
the market for U.S. Treasuries by becoming a major buyer (thus blurring the
line between monetary and fiscal policy), let’s just leave it that the country’s
balance sheet is structured not unlike those of the irresponsible banks that loaded up on short-term financing in the
lead up to the financial crisis. The Treasury’s reliance on funding government
through these instruments makes sense as long as the honeymoon (ultra-low
rates) lasts. As already stated, should rates increase before authorities have
made headway on fiscal adjustments, interest payments will spike, much of which
will be funneled to foreign bondholders, and the country’s debt load will climb
higher into Hellenic territory. This doomsday scenario, along with Washington’s
dysfunction in addressing it, was a key reason cited in the downgrade of the
country’s credit rating. Careening off the fiscal cliff or (more likely)
kicking the can down the road, could lead to further rating cuts. In the past
the U.S. has gotten away with profligacy as its bonds are considered the safest
and most liquid instruments around. Although authorities can still bank on this
in the short-run, eventually it will change. Even if still on the distant horizon,
we can still expect Treasuries to be in for a bumpy ride once the Fed lets its
foot off of the QE accelerator. Eventually it must. Otherwise, the institution’s
credibility (what’s left of it) will take a hit. With the removal of the Fed’s
outsized role in the market, bonds will likely sell off, raising borrowing
costs across the economy and causing significant hits to portfolios that have
loaded up on fixed income over the past few years. Less credit to fuel growth,
a diminished wealth effect to cause investors to skimp on beach trips and
dinners out.

The Dollar: What the World
Thinks of Us

As with the Treasury market, the dollar has been the beneficiary of
America’s preeminence in the global economy, functioning as the world’s
de-facto reserve currency. This reality explains that despite such QE-induced low
yields on U.S. Government instruments, the greenback has surprisingly
maintained its value, with the broad-Dollar index being off only 8% against a
basket of major currencies since its most recent peak in 2010. While there are
no obvious alternatives to the dollar, unless one is a tried and true gold bug,
eventually international investors will diversify away from overweight holdings
of the U.S. currency. This transition will only be hastened should authorities
not address fiscal issues as well as fail to create conditions for robust
growth. Some argue that a weak dollar would aid the rebalancing process with
consumption being curtailed as the prices of imports rise and U.S. made exports
become more competitive in the global marketplace. Possible. But given the
relatively small slice of GDP that trade accounts for, along with the price
insensitivity of our major, high value-added exports, net/net the small export
boost would be more than offset by imported inflation.

Commodities Super Cycle Meets
Domestic Energy Revolution

The main channel through which inflation would rear its ugly head
would be raw materials, namely energy products. The question remains whether
the Obama Administration will truly embrace the energy revolution occurring in
North America, as it began to do during the campaign, or will the EPA continue
to erect hurdles for drilling on public lands and perhaps wade into the waters
of hydraulic fracturing and place restrictions on that activity. While in the
past many have sneered at the concept of energy independence as nothing more
than jingoistic campaign rhetoric, new extraction techniques could greatly
reduce the country’s reliance on foreign energy sources and in the process
bring down the chronic current accounts deficit, much of which is attributable
to energy imports. Furthermore the possibility of exporting natural gas via LNG
terminals and taking steps to globalize these currently local markets, would
further enhance the country’s trade balance and also have the added benefit
putting pressure on an increasingly cantankerous Russia (think Syria) by
competing directly with one of the Putin Regime’s greatest sources of revenue.

Then there is the Keystone Pipeline. Without its completion and other
such infrastructure projects, the Canadians will happily export their treasure
trove of energy to Asia. Relieving the supply bottleneck in the central U.S.
would allow crude to flow into global markets, closing the price gap between
WTI and BRENT. But rather than resulting in across-the-board higher prices, the
global market would find a new (lower) equilibrium. East Coast drivers would
likely benefit as experts have shown gasoline prices there have been tracking
the more expensive BRENT contract. Capitalizing on domestic hydrocarbon sources
(apologies to the Greenies reading this) would boost the economy in multiple
ways. Not only would jobs for gulf coast refiners be created, as well for transit
construction projects, but more importantly, higher supply helps consumers by
lowering prices, thus freeing funds to be spent on other purchases. Think of it
is a form of stimulus; only this time, one that works.Abundant sources of natural gas could also tilt
energy-intensive manufacturers into reestablishing a presence in rust-blighted
regions, many of which border major fields like the Marcellus Shale.

What Verdict Will Stocks
Render?

Rather than reading too much into the two-day sell-off following the
election, or jump into the conversation about current valuation levels, we’ll
highlight how a second Obama administration can harness the power of the
corporate sector and consequently how share performance can provide a progress
report on Washington’s initiatives. Presently companies are timid; this is best
illustrated by the $1.76 trillion of cash on their balance sheets as recently
reported by S&P. One does not invest in equities to have them deposit your savings
into low-yielding short-term instruments. You can do that on your own at the
community bank…if it had not gone under in 2009. The whole point of investing
in stocks is the expectation that management can consistently identify
investments (new markets and products) that will return more than their cost of
capital. It is government’s role to create the conditions for corporate leaders
to seek out such investments. Presently key sectors such as financial services
and energy must navigate a jungle of regulations, which not only jack-up their
compliance costs, but more importantly increasingly dictate operational
decisions such as what business lines they can enter (or must leave).

By creating fertile ground for growth, the Administration can serve
its own ends by giving business leaders the confidence to deploy idle cash.
Likely targets would be capital goods purchases and hiring workers. The former
would increase productivity (a key ingredient to long-term growth) and help
industrial firms, the latter would address what should be issue numero uno and finally give consumers
the confidence to replace items that have their best days behind them. The
release of such pent-up demand is all the more important in an economy that for
the near term will still have consumption comprise a 70% slice.

Corporate tax rates brought down to international norms would also
improve the competitiveness of U.S. enterprises, as well as would the removal
of punitive measures on repatriating foreign earnings. Officials must recognize
that, despite the U.S. address, these are truly multinational companies and
their goal is to invest where the potential return is the greatest. Increasing
America’s attractiveness as a destination for investment will help loosen the
needed capital to kick start the sustainable growth that has been elusive over
the prior four years. Failure to unleash the ingenuity of the corporate sector
will further nudge U.S.-domiciled firms into investing in plants and jobs
overseas. In this scenario, investors in sectors with substantial international
exposure may do OK. Domestic sectors would not. In both cases, U.S. workers and
consumption would likely take yet another hit.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.